Corporate Finance Principles

• Corporate finance focuses on how companies manage value and capital.
• It encompasses investment decisions (capital budgeting), financing decisions (capital structure), and dividend policies.

Core Principles

• Maximizing shareholder wealth is the primary goal of corporate finance.
• The time value of money suggests that money available today is worth more than the same amount in the future due to its potential earning capacity.
• Risk and return are directly related; higher returns typically come with higher risks.
• Efficient markets reflect all available information, making it difficult to consistently achieve returns above the average.

Capital Budgeting

• Capital budgeting is the process of evaluating potential investments.
• Techniques include Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period, and Profitability Index (PI).
• NPV calculates the present value of expected cash flows minus the initial investment.
• Projects with a positive NPV are generally accepted as they are expected to increase shareholder wealth.
• IRR is the discount rate that makes the NPV of a project equal to zero.
• Projects are accepted if the IRR exceeds the cost of capital.
• The Payback Period measures the time it takes for a project to recover the initial investment.
• It is simple but doesn't account for the time value of money or cash flows after the payback period.
• The Profitability Index (PI) is the ratio of the present value of future cash flows to the initial investment.
• A PI greater than 1 indicates that the project should be accepted.
• Discounted cash flow (DCF) analysis is a method of valuing an investment using the time value of money.
• It involves projecting future cash flows and discounting them back to their present value.
• Sensitivity analysis helps to measure the impact of changing input variables on the outcome of a project.
• Scenario analysis evaluates the financial outcome of a project given different possible scenarios.

Capital Structure

• Capital structure refers to the mix of debt and equity a company uses to finance its operations.
• Debt financing involves borrowing money, which must be repaid with interest.
• Equity financing involves selling ownership shares in the company.
• The optimal capital structure balances the benefits and costs of debt and equity.
• Financial leverage is the use of debt to amplify returns on equity.
• While it can increase profits, it also increases financial risk.
• The weighted average cost of capital (WACC) represents the average rate of return a company must earn to satisfy its investors.
• It is used as the discount rate in capital budgeting decisions.
• Factors affecting capital structure decisions include:
  • Tax rates: Interest payments on debt are tax-deductible, which lowers the effective cost of debt.
  • Financial flexibility: Maintaining financial flexibility is important to ensure that the company can raise capital when needed.
  • Industry norms: Companies often follow the capital structure practices of other firms in their industry.

Dividend Policy

• Dividend policy involves decisions about how much of a company's earnings to distribute to shareholders versus reinvesting in the company.
• Dividends can be paid in the form of cash, stock, or property.
• Stock repurchases are an alternative to dividends, where the company buys back its own shares.
• Factors influencing dividend policy include:
  • Company's profitability and cash flow
  • Investment opportunities
  • Shareholder preferences
  • Legal and regulatory constraints
• The dividend irrelevance theory suggests that dividend policy has no impact on the value of the firm in a perfect market.
• In practice, dividends may signal a company's financial health and future prospects.
• Clientele effect: different investors prefer different dividend policies.

Working Capital Management

• Working capital management involves managing a company's current assets and liabilities.
• The goal is to ensure that the company has enough liquidity to meet its short-term obligations.
• Key components of working capital include:
  • Cash: Managing cash balances and short-term investments.
  • Accounts receivable: Managing credit policies and collecting payments from customers.
  • Inventory: Managing inventory levels to minimize costs and avoid stockouts.
  • Accounts payable: Managing payments to suppliers.
• The cash conversion cycle (CCC) measures the time it takes for a company to convert its investments in inventory and other resources into cash flows from sales.
• A shorter CCC indicates greater efficiency.
• Factoring is the sale of accounts receivable to a third party (the factor) at a discount.
• This provides immediate cash flow but at a cost.

Mergers and Acquisitions (M&A)

• M&A involves the consolidation of companies.
• A merger is the combination of two companies into one.
• An acquisition is the purchase of one company by another.
• Motives for M&A include:
  • Synergy: Combining operations to achieve greater efficiency and cost savings.
  • Market share: Increasing market share by acquiring a competitor.
  • Diversification: Expanding into new industries or markets.
  • Access to new technology or intellectual property.
• Valuation methods for M&A include:
  • Discounted cash flow (DCF) analysis.
  • Relative valuation (comparing the target company to similar companies).
  • Precedent transactions analysis (analyzing past M&A deals).
• Hostile takeovers occur when the target company's management does not agree to the acquisition.
• Defensive tactics can be used to resist a hostile takeover, such as poison pills and white knights.

Risk Management

• Risk management involves identifying, assessing, and mitigating financial risks.
• Types of financial risks include:
  • Market risk: Risk of losses due to changes in market prices or interest rates.
  • Credit risk: Risk of losses due to a borrower's failure to repay a loan.
  • Liquidity risk: Risk of being unable to meet short-term obligations.
  • Operational risk: Risk of losses due to errors, fraud, or disruptions in business processes.
• Hedging involves using financial instruments to reduce or eliminate risk.
• Derivatives are financial contracts whose value is derived from an underlying asset.
• They can be used for hedging or speculation.
• Value at Risk (VaR) is a statistical measure of the potential loss in value of an asset or portfolio over a defined period for a given confidence interval.
• Stress testing involves simulating extreme market conditions to assess the impact on a company's financial position.

Financial Statement Analysis

• Financial statement analysis involves analyzing a company's financial statements to assess its performance and financial condition.
• Key financial statements include:
  • Income statement: Reports a company's financial performance over a period of time.
  • Balance sheet: Reports a company's assets, liabilities, and equity at a specific point in time.
  • Statement of cash flows: Reports a company's cash inflows and outflows over a period of time.
• Ratio analysis involves calculating and interpreting financial ratios to assess various aspects of a company's performance.
• Examples of financial ratios include:
  • Liquidity ratios (e.g., current ratio, quick ratio)
  • Solvency ratios (e.g., debt-to-equity ratio, times interest earned)
  • Profitability ratios (e.g., gross profit margin, net profit margin, return on equity)
  • Efficiency ratios (e.g., inventory turnover, accounts receivable turnover)
• Trend analysis involves analyzing financial data over time to identify trends and patterns.
• Common-size analysis involves expressing financial statement items as a percentage of a base figure (e.g., total assets or total revenues).